Moral Hazard is Catching
By Adrian Ash
April 4, 2007
From LTCM to the 'Ohio Put'
in nine years of easy money...
THIRTEEN YEARS AGO, the giant German industrial
conglomerate Metallgesellschaft lost $1.5 billion trading crude
oil futures.
It admitted afterwards that it knew
little-to-nothing about the oil market.
The next year, in 1995, Barings bank – one of
Britain's oldest and most respected financial institutions –
went bust thanks to a lone trade in Singapore losing some $860
million on Japanese stock futures.
The head office in London claimed it knew nothing
about Nick Leeson's repeated strategy of 'double or quits'.
In 1996 Sumitomo, the world's biggest copper
trader, discovered it had lost $2.6 billion thanks to a rogue
trader of its own. Yasuo Hamanaka hid the losses so well, it had
taken him nearly a decade to build them up!
And then in 1997, two professors from Harvard won
the Nobel Prize for Economics for services to easy money. They
claimed to know pretty much everything, and weren't shy of
sharing their knowledge for a fee.
All it took to make big profits, said Myron Scholes
and Robert C. Merton, was a clever little formula. Oh, and a
huge position in derivative contracts, gearing up tiny movements
into large, volatile swings in options prices. Funnily enough,
gearing up tiny movements into large, volatile swings in options
prices was also all it took for Long-Term Capital Management to
blow up in 1998.
Both of the Harvard laureates sat on the hedge
fund's board of directors. LTCM lost some $3.5 billion. And when
the New York Fed learnt of the disaster, it rushed to put
together a rescue package for the fund's creditors.
Four companies, five years and $8.4 billion in
losses. Glancing back from here in spring '07, the funniest
thing is how quaint and innocent all these derivatives disasters
look today – never mind how quaint they could look by this
time next year.
"The Federal Reserve provided its good offices
to LTCM's creditors, not to protect LTCM's investors, creditors,
or managers from loss, but to avoid the distortions to market
processes caused by a fire-sale liquidation and the consequent
spreading of those distortions through contagion."
So said Alan Greenspan, then chairman of the US
Federal Reserve, in Oct. 1998.
"To be sure, this may well work to reduce the
ultimate losses to the original owners of LTCM, but that was a
byproduct, perhaps unfortunate, of the process."
Fast forward eight-and-half-years, and the
unfortunate byproduct of the LTCM rescue is still known as the
"Greenspan Put" – even though Sir Alan of Greenspan
climbed aboard the consultancy gravy-train back in Jan. 2006.
Does his eponymous "put option" remain
available today to over-geared speculators? News from Ohio says
that the logic of the Greenspan Put has seeped far beyond the
paper securities traded on Wall Street.
"Do you have an adjustable rate mortgage (ARM)
and worry about how you are going to make your monthly mortgage
payment once the loan enters the adjustable phase?" asks
the Ohio Housing Finance Agency (OHFA) on its homepage.
"The Opportunity Loan is a refinance program
that provides an affordable 30-year, fixed-rate financing
alternative to borrowers who feel their current loan does not
fit their financial circumstance," the OHFA goes on.
The loans, available from Monday, 2nd April, seem
to represent some kind of breakthrough in state-sponsored aid to
over-geared speculators. (Vermont's housing finance agency will
also help with refinancing, but only on qualifying mobile
homes.)
Who's being saved from themselves here isn't quite
clear. Subprime homebuyers couldn't get a sensible home-loan
even before credit standards were tightened in the face of the
subprime collapse. Whereas the mortgage lenders, on the other
hand, are dreading a further surge in delinquency rates and a
further collapse in unsold inventory prices. The moral hazard of
stalling foreclosure can only buy time.
Still, Ohio's new Opportunity Loans carry a fixed
interest rate of 6.75%. Borrowers earning up to 125% of their
county's median income will be able to apply. And why not?
"Ohio leads the nation with 11.32% of sub-prime loans in
foreclosure and 3.38% of all housing loans in foreclosure,"
as Martin Hutchinson notes for BreakingViews.com.
The other 54 housing finance agencies in the United
States are no doubt tracking Ohio's fortunes closely. Moral
hazard is catching, remember. Just ask Ben Bernanke! He caught
it from his ex-boss.
"The principal policy issue arising out of the
events surrounding the near collapse of LTCM is how to constrain
excessive leverage," said the President's Working Group on
Financial Markets in April 1999. Often referred to as the Plunge
Protection Team, the Working Group fretted that the bankruptcy
of LTCM "could have potentially impaired the economies of
many nations, including our own" if the Fed hadn't stepped
in so ably and so quickly.
Leverage since then, however, has merely switched
markets – and swollen – rather than receding again. First it
poured into margin accounts for private day traders...and then
it sloshed into houses that no one could afford without
exploding ARMs and neg-am mortgages.
There's nothing to fear, of course, for as long as
the money keeps flowing. The Fed will underwrite your chosen
excess. Move tables if you must, but please – do keep gaming.
And besides, "leverage in most hedge funds is
generally much less than is true for most large banks and
securities firms," as the professors of the Financial
Economists Roundtable put it just after the LTCM collapse. So
why fret about the hedge funds when the banks and brokers are so
even more heavily geared? And why fret about the banks and
brokers now that low-earning homebuyers owe six, seven or more
times their gross income?
"All this takes us to a rather disturbing
bi-modal endgame," writes Stephen Roach of Morgan Stanley
in a note – "the bursting of the proverbial Big Bubble
that brings the whole house of cards down, or the inflation of
yet another bubble to buy more time.
"The exit strategy is painfully simple:
Ultimately, it is up to Ben Bernanke – and whether he has both
the wisdom and the courage to break the daisy chain of the
Greenspan Put."
So far, no dice. Dr. Bernanke has yet to face
expiry or exercise, in fact. His predecessor's undated promise
to Wall Street has now been extended to Main Street as well.
But with Dollar interest rates up at 5.25%, there
are 17 baby-steps between here and the "emergency"
rate Greenspan imposed in response to the Tech Stock collapse.
How low might Bernanke now go?